Key developments in classification and measurement of financial instruments

The FASB proposed updated guidance for the classification and measurement of financial instruments in February 2013. However, as a result of significant negative feedback, the FASB has dramatically changed its proposal. As a result, convergence with the IASB will not be achieved.

Equity investments (not accounted for under the equity method) with readily determinable fair values will be measured at fair value, with changes in fair value recognized in net income. However, entities other than investment companies and broker-dealers will be afforded a practicability exception for investments that do not have readily determinable fair values. Such investments would be measured at cost less impairment and adjusted for observable prices. The accounting for debt investments (i.e., loans and debt securities) will remain unchanged subject to the new proposed impairment model (see below).

The unrestricted fair value option that currently exists in U.S. GAAP will be retained.

Financial liabilities will generally be recorded at amortized cost unless the fair value is elected. If the fair value option is elected for a financial liability, adjustments to the value due to changes in instrument-specific credit risk will be recorded in other comprehensive income.

The requirement to assess hybrid financial instruments for the need to bifurcate embedded derivatives from their host and account for them separately remains. To the extent that an embedded derivative must be bifurcated and accounted for separately, it will be measured at fair value with changes in fair value recognized in net income.

The IASB issued its final guidance on targeted amendments to its classification and measurement standard in July 2014. The IASB’s classification and measurement standard is substantially the same as the FASB model that was proposed in the ASU issued in February 2013.

Key developments in impairment of financial instruments

In 2012, the FASB and IASB moved in different directions in their approaches to developing a new impairment model for financial assets.

The IASB's approach would classify debt investments into categories that reflect the pattern of credit deterioration over time. Those categories would dictate the model for determining the amount and timing of when credit losses would be recognized in earnings. All assets would initially be recognized in the first category, where a credit loss would be recorded based on the probability of a default in the next twelve months. Once an asset experiences a significant deterioration in credit risk, it would move to a second category, at which point an allowance would be recorded for the full lifetime expected credit losses.

The FASB believes that aspects of the IASB's model are difficult to implement and would result in a credit allowance that does not fully capture all expected losses on an asset. Prior to experiencing a significant deterioration in credit, the IASB model would only record expected losses for assets expected to default within 12 months of the balance sheet date. Thus, the FASB opted for a model that requires recognition, at the inception or acquisition of a financial asset, of an allowance for the full amount of contractual cash flows not expected to be collected. The FASB issued an exposure draft on its model, referred to as the current expected credit loss (CECL) model, in December 2012.

Generally, respondents to the IASB model supported the proposed model, but suggested various refinements. The IASB issued its final standard during the third quarter of 2014.

With respect to the FASB model, feedback was mixed. Users generally supported the FASB model, as they preferred a model that would require recognition of all credit losses (as opposed to only ‘some’ expected credit losses). Preparers, on the other hand, did not support the FASB’s proposed model, struggling to reconcile the recognition of credit losses at the inception of a lending arrangement with the credit assessment inherent in the pricing of the transaction. Instead, preparers preferred a model that would recognize those losses expected to occur in the ‘foreseeable future’ or some other truncated period.

Throughout the fall of 2013, the FASB conducted outreach with both preparers and users, and conducted joint discussions with the IASB. Ultimately, after considering several alternatives, the FASB decided in December 2013 to move forward with the CECL model and refine various aspects, where necessary. That decision eliminates the possibility of convergence between the FASB and IASB in the recognition and measurement of credit losses. The major difference between the IASB and FASB’s models is the credit deterioration trigger in the IASB’s model—that is, the FASB will require recognition of full lifetime expected credit losses upon initial recognition, whereas the IASB would record such losses upon a significant deterioration in credit.

Following its decision to move forward with the CECL approach, the FASB has continued to refine that model. Specifically, the board decided that the CECL model should apply to all financial assets measured at amortized cost. For debt securities measured at fair value with qualifying changes in fair value recognized in other comprehensive income (FV-OCI), the board decided that use of an impairment model similar to that in current guidance would be most appropriate, with the following proposed changes.

– An allowance approach would be used to recognize impairment losses, which would allow an entity to recognize reversals of credit losses to the extent improvements occur.

– Removal of the requirement to consider the length of time that the fair value of an available for sale debt security has been less than its amortized cost when estimating whether a credit loss exists.

– Removal of the requirement to consider recoveries or additional declines in fair value of an available for sale debt security.

The FASB also decided that for loans subsequently reclassified as held-for-sale and measured at the lower of cost or market, the amortized cost basis on the transfer date would be considered the loan’s cost basis and a valuation allowance should be recorded equal to the amount by which amortized cost exceeds fair value. For debt securities subsequently identified for sale, the full difference between fair value and amortized cost would be the amount of impairment recorded.

The FASB clarified the determination of when a write down to an allowance for credit losses should occur, deciding that instruments uncollectible in full or in part would require a write down, which is similar to the existing guidance for loan receivables.

The FASB concluded that contractual cash flows, as defined in the proposed standard, would not include forecasts of extension, renewals or modifications unless the entity expects that such forecasts would be related to a troubled debt restructuring. Estimation of prepayments would be allowable under the standard. It was reaffirmed that expected credit losses for unfunded loan commitments should reflect the full contractual period over which the entity is exposed to credit risk, unless unconditionally cancellable by the issuer.

The FASB discussed requiring that the allowance related to new originations be disclosed separately in the rollforward of reserves. The board is currently conducting outreach regarding the practical feasibility and information usefulness of this potential requirement.

The FASB’s decisions on the classification and measurement of debt investments represent a major change from its proposed model and are a significant setback to achieving global convergence in this area.

Many believe that financial instruments accounting is overly complex and sometimes results in inconsistent information being reported for economically similar instruments.

Some stakeholders believe that the financial crisis highlighted the need for potential improvements in how and when impairment losses are recognized on loans, investments in debt, and related securities. Both boards' models attempt to respond to these constituent concerns, albeit in different ways.

What's next for the financial instruments project?

Classification & measurement: The FASB will continue redeliberations on this project and expects to issue a final standard in the first half of 2015.

Impairment: The FASB will continue redeliberations on the CECL model, considering feedback received through comment letters and outreach activities.

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